The Bank of Japan (BOJ) is being encouraged to continue or ease its plans for reducing bond purchases beyond fiscal 2026. This recommendation comes in light of recent fluctuations in super-long Japanese government bond yields and a dip in demand. In May meetings, many participants suggested maintaining or only slightly lowering bond purchases. The BOJ plans to cut its monthly bond purchases to ¥3 trillion by March 2026. Some members advocate for reducing this to ¥1–2 trillion per month, while others suggest keeping the current rate or pausing cuts for super-long bonds due to liquidity worries. This range of opinions shows the challenges facing the BOJ. The central bank will review its approach during the policy meeting on June 16–17.

Calls for More Flexibility

During the meeting, participants requested more flexibility, especially regarding super-long bonds. Some warned against reacting too quickly to shifts in market conditions, as weak demand could hinder the BOJ’s ability to manage volatility. Despite ending negative interest rates and starting a gradual taper, the BOJ still owns nearly half of all outstanding Japanese Government Bonds (JGBs), lagging behind other countries in reducing support initiated during the crisis. This situation highlights recent tensions around the Bank’s bond purchasing strategy. With yields for longer maturities becoming erratic and buyer confidence dwindling, various voices are urging the BOJ to either slow down or halt their plans to cut support. The goal was to halve monthly purchases by the end of fiscal 2026. However, lower demand for longer-term bonds is raising concerns among both policymakers and market analysts. The upcoming review on June 16–17 will be crucial in determining the BOJ’s next steps. At recent policy discussions, some members have advocated for a more cautious approach, noting decreased demand and potential fragility in market dynamics. The risk of unpredictable pricing is also a significant concern. These worries are justified, as yields on super-long bonds have recently fluctuated more than usual. The primary issues now revolve around liquidity and unstable trading conditions rather than long-term inflation or growth. Lately, we’ve noticed yield gaps widening more than usual during quieter market hours. This trend indicates a decline in market depth and resilience. While a slight reduction in purchases might be manageable for shorter-term bonds, it could be wiser for the central bank to delay cuts for longer maturities. Being flexible with tapering can improve market stability and prevent disruptions, especially in the current climate of uneven sentiment and one-sided investor flows.

Considering Market Constraints

With the BOJ’s bond holdings comprising nearly half of all outstanding bonds, the market may feel overly dependent on a single entity. This dependence restricts traders and limits their exit options, potentially leading to more frequent liquidity issues, particularly with off-the-run bonds or those with longer maturities, which carry greater risk. It may be too early to price in taper reductions for super-long bonds given the volatility observed in the 20- and 30-year maturities, suggesting that the market hasn’t fully absorbed the current supply. If the BOJ were to slow down or pause reductions, it would be prudent to adjust their strategy accordingly. Risk management should involve tighter limits for these maturities, and adjustments for breakeven points should reflect wider fluctuations, typically exceeding ±6 basis points throughout the trading day. Current market depth metrics have not yet returned to the levels seen before the pandemic. One challenge now is predicting policy changes that respond to liquidity issues, creating a complex feedback loop. Longer-term bond auctions may underperform without clear signals from the central bank. For now, focusing on shorter durations, where price discovery is more accurate and demand remains decent, may be the best approach. Additionally, recent shifts in swap rates indicate that forward curves might not be reliable indicators. The small but consistent discrepancy between physical and synthetic pricing introduces uncertainty around actual expectations. This complicates efforts to hedge against taper signals through futures or swap spreads. In summary, timing is crucial. If support is pulled back too soon while demand remains weak, it could lead to chaotic market behavior, which must be avoided. It’s better to wait for a clearer view on capital movement before tightening liquidity further in an already thin market. We will closely monitor auction results and bid-to-cover ratios over the next two cycles. Significant declines in these areas could lead us to anticipate widening spreads in relation to European markets. Create your live VT Markets account and start trading now.

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